The Federal Reserve hiked another half-point in interest rates on Wednesday, reviving concerns that the Federal Reserve and other central banks are poised to trigger a recession if it is necessary to bring inflation under control.
“Don’t fight the Fed” is a much-cited market adage that has remained wise advice for the past decade or two. Lately, however, it seems investors are negating that advice.
This week, Fed Chair Jerome Powell and his members of the Federal Open Market Committee issued another warning that they see a protracted fight against inflation well into next year. With bond yields falling and equity indices rising, financial markets appear to have disagreed. Who will prove right will have a major impact on what happens to the financial markets in the new year.
Recent good news on the inflation front – lower monthly Personal Consumption Expenditure (PCE) and Consumer Price Index (CPI) data – have convinced investors that inflation is on the rise. The expectation that core inflation could fall as low as 2.6 percent by the end of 2023 is the bull case. They argue that disruptions in global supply chains were the main cause of the rise in inflation. This problem is quickly disappearing and so is inflation.
In that case, inflation could fall to the Fed’s target rate of 2 percent within the next 12 months. Some investors believe that not only does the Fed need to hold back from raising interest rates, it will likely start cutting rates to stave off a serious recession. As a result, the bulls have been bidding up stocks and buying bonds.
The Fed is at the other end of the spectrum. Powell has noted on several occasions that headline inflation, as represented by the producer price index and consumer price index, is not a good indicator of the true rate of inflation. Why?
This is because energy, durable goods and housing are three areas that feature heavily in these indices and are heavily impacted by supply chain disruptions. The Fed is looking more at variables like service prices, which are labor intensive and more related to aggregate supply and demand. That puts employment squarely in the central bank’s crosshairs, and it sees little slowdown in job growth.
Despite two monthly declines in the inflation rate represented by the CPI, the Fed has revised its forecast for inflation next year to 3.1 percent and its forecast for core inflation (excluding food and energy) to 3.1 percent from 3.1 percent. raised 5 percent.
The Fed, too, sees meager GDP growth (+0.5 percent), while many economists had forecast at least a moderate recession starting in Q1 or Q2 2023, with bulls believing a mild recession at best will bring inflation rates down quickly as supply chains continue to recover and expand.
In my view, there are a few flies in this ointment. Even if inflation was solely the result of supply chain disruptions, why are bulls so sure that supply chain problems will go away and never come back?
China, the main cause of these disruptions, is abandoning its zero-COVID policy, but as a result, the rate of infection among the Chinese population is skyrocketing, with the real possibility that supply chains could come under renewed pressure. Our own country is not immune to another resurgence of COVID and potential supply chain issues.
Omicron BQ and XBB are COVID subvariants that currently cause 72 percent of new infections in the US. They are the most immune-preventable variants of COVID-19 to date. Current vaccines and booster vaccines are “poorly susceptible” to neutralizing the disease, according to the Centers for Disease Control (CDC). The holiday season could usher in a big spike in infections with all the associated productivity losses.
In my opinion, it seems far too early to claim victory on the inflation, interest rate and growth fronts. This week’s disappointing FOMC meeting could convince investors that stocks are ahead of themselves. So far we have not been able to break the upper end of my target range (4,000-4,100) on the S&P 500 index. “Don’t fight the Fed” seems like good advice to me.
I remain cautious and believe markets will need to pull back to test the 3700-3800 level in the S&P 500.
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